citi velocity - from evolution to revolution: esg ......source: citi business advisory services; aum...

1From Evolution to Revolution: ESG Considerations Beginning to Re-Shape Investment Management

FROM EVOLUTION TO REVOLUTION:

ESG CONSIDERATIONS BEGINNING TO

RE-SHAPE INVESTMENT MANAGEMENT

September 2020

Business Advisory [email protected]

Intended for Institutional Clients Only

2 From Evolution to Revolution: ESG Considerations Beginning to Re-Shape Investment Management


Table of Contents

Methodology 4

Key Findings 6

Section I: Understanding the Rise of ESG Investing 10

Section II: Current ESG Investments Focus on Managing Headline Risk 22

Section III: COVID-19 Intensifies Focus on Effectiveness of Capital Allocation to Mitigate Pre-Financial Risks 36

Section IV: Phase 2A—Redesigning Equities Investing with an ESG Lens 49

Section V: Building Multi-Asset Class Dual Return Solutions 63

Conclusion 77 Disclaimer 79


Methodology

This ESG-focused report builds on the themes explored in the recently published 2020 Industry Evolution Survey: Health & Real Economy Crises Rock the Investment Management Industry, which was the 10th annual version in the series. We conducted 105 in-depth interviews with firms that collectively managed $53.7 trillion of AUM, or 63% of 2019’s total professionally managed AUM.1 We also organized more than 100 playback meetings with firms across the industry, in which we discussed our findings and further explored the impact of Environmental, Social, and Governance (ESG) priorities.

We interviewed investors and intermediaries representing approximately $4.4 trillion in assets. Participants included sovereign wealth funds, public and corporate pension funds, insurers, private banks, and wealth advisors as well as a number of emerging technology firms. Investment managers comprised 73% of our interviews and represented more than $49.3 trillion of AUM. These included a variety of asset managers, hedge funds, and private asset firms.

Our interviews encompassed a wide variety of roles: CEOs, CIOs, COOs, CFOs, Business Heads, Senior Portfolio Managers, and other investment professionals. The 105 in-depth interviews included views from over 110 individuals. The geographic breadth and broad spectrum of firms that participated laid out numerous assumptions for the future of the investment management industry.

During the course of each interview, we had an open-ended discussion in which interviewees voiced their views on how the investment management industry may be transformed. While we maintained questions focused on our typical 18-36 months forward looking

1 Citi Business Advisory Services analysis based on data from “Global Asset Management 2020: Protect, Adapt, and Innovate”, The Boston Consulting Group, May 19, 2020, https://www.bcg.com/en-gb/publications/2020/global-asset-management-protect-adapt-innovate; and proprietary data subscriptions to Preqin, Hedge Fund Research

and ISS Market Intelligence SimFund.

view, many of our conversations discussed how industry participants are approaching and integrating ESG into their investment and corporate decision-making processes. Given the depth of those findings, we wrote a dedicated paper on ESG to analyze the industry implications.

As in previous reports, you will find a selection of anonymized quotes throughout the report to give a flavor of the insights shared by interviewees.

In the following charts, we show the range of firms interviewed, as well as a geographic breakdown of both our interviewees and the client presentations of the 2020 Industry Evolution paper. The views on ESG expressed in those meetings further enhanced the findings of this report.

We are delighted to share the findings of our 2020 ESG paper. We would like to express our gratitude to all those individuals who participated in our survey and were so generous with their time and their thoughts. Thank you.

Breakdown of Interviews by Client Type

105 Interviews Globally $53.7T

Investors & Intermediaries

20%

Others7%

Investment Managers

73%

InvestmentManagers

77 InterviewsAUM = $49.3T

Asset Owners, Intermediaries, &

Others28 Interviews AUM = $4.4T

Source: Citi Business Advisory Services; AUM from eVestment and Company Websites


Geographic Breakdown of 105 Interviews

EMEA37

35%Americas

5855%

APAC10

10%

Source: Citi Business Advisory Services

Geographic Breakdown of 101 Playbacks Presentations

EMEA34

34%Americas

5554%

APAC12

12%



Key Findings

We have tracked the growth of Environmental, Social, and Governance (ESG) investing in our reports for many years, but never has the topic garnered so much attention, nor spurred so much debate as in our 2020 Industry Evolution survey interviews that began in March-April 2020. Survey participants were eager to share their views on ESG’s evolution, even amidst the myriad challenges of rapidly deteriorating markets, volatility, liquidity concerns, and the operational challenges of transitioning to remote workforces.

1 2018 Global Sustainable Investment Review, Global Sustainable Investment Alliance, 2018, http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf2 Ibid

Although some participants warned that the market turmoil might be the end of ESG, the clear majority saw the nature of the crisis–a global borderless, and virulent health pandemic—as uniquely suited to being viewed through an ESG lens. The wide-ranging insights shared about ESG in this year’s Industry Evolution Survey interviews, covered so much ground that we chose to elevate the topic and really explore the ESG landscape in more depth as many see the industry at an inflection point around this trend.

In this paper, we address key developments that support this conclusion and explain how even those who might still be ESG skeptics (as some of our Business Advisory Services members once were), may now need to reconsider whether ESG might represent the most significant opportunity in decades for the investment management industry.

We chose to start our exploration by clearing up some of the ambiguities around ESG and how it may differ from other types of socially responsible investing, and by trying to cut through some of the complexity of the ESG ecosystem. Survey participants view the current ESG space as a significant source of confusion, with its jargon and acronyms and broad range of partici-pants–governments, NGOs, specialty organizations, and industry groups—all pursuing, publishing, and promoting a plethora of rules, frameworks, goals, and standards, both actual and proposed.

Underlying this mélange of activity, however, is a growing pool of assets that are being awarded to investment managers for the express purpose of addressing the needs of investors in pursuing ESG-related goals. This is neither, as many initially framed it, a European phenomenon, nor is it exclusively a climate change-related concern.

The range of asset owners across the globe shifting their portfolios towards ESG is significant and growing. This report looks at the roots of ESG investing, its expression in today’s investment landscape, how the evolving demands of asset owners may prompt a significant change in the way that ESG investing occurs, and what that future may look like.

Current ESG Investments Focus on Managing Headline Risk

AUM allocated to ESG investments was estimated at $30.7 trillion in 2018, and while these assets have likely grown since, the underlying investment techniques are still nascent.1 Early efforts have focused on broad brush approaches that look to avoid the headline risk of owning companies with poor ESG records. These investment strategies most commonly exclude companies (“Negative Screening”, $19.8 trillion), or integrate ESG alongside a wide array of other financial considerations in determining the weighting of a security in a portfolio (“ESG Integration”, $17.5 trillion).2

There are several issues with these approaches:

They do not tie the allocation of investment dollars to specific corporate behaviors that the investment manager is looking to highlight, and thus the effectiveness of these investments to incentivize actual change around any E, S, or G concern is uncertain.

The data approach used to “score” companies is opaque and many survey participants questioned its utility.

There is considerable variety in how investment managers incorporate ESG into their organiza-tions. In some models, the existence of separate groups outside the investment team who are focused on ESG and shaping firm policy on how it gets reflected in portfolios, can undermine the potential for financial return or the translation of the ESG signals into actual holdings.

Strategies that engage companies more directly—stewardship and impact funds—may be more effective in signaling desired ESG behavior changes, but the measures used to evaluate their success often focus on actions taken as opposed to outcomes achieved. Moreover, of the ESG approaches in use today, these strategies currently attract the smallest amounts of AUM.


COVID-19 Intensifies Focus on Effectiveness of Capital Allocation to Mitigate Pre-Financial Risks

The COVID-19 pandemic has brought with it a new awareness of the breadth and variety of risks that can influence asset values. Climate change had previously been the primary focus of ESG discussions, but the shift from “E-concerns” to “S-concerns” driven by the speed, extent, and origin of the crisis have created a new dialog and sense of urgency around systemic risks, and how extensively such pre-financial risks can affect investment portfolios in unexpected ways.

Corporate access to capital, the relative cost of such capital, and transition plans on how companies will deploy funds to enhance their sustainability profile are already impacting banking relationships in key sectors, as lenders look to reduce risks to their portfolios. COVID-19 experiences are expanding such considerations and increasing focus on how societal risks might affect capital decisions is anticipated.

Asset Owner Goals Shift in Response to Cascading Systemic Risks: The lessons of COVID-19 are driving asset owners to re-examine their approach to managing ESG risks, as they recognize that systemic events can have cascading effects that existing risk models are not well-suited to identify or address. Survey participants expressed a growing awareness that pre-financial risks may upend portfolios at any time, not only because of the interconnectedness of the global economy and the vulnerabilities this creates during systemic risk events, but also because of amplified stakeholder voices that impact a company’s social license to operate.

Survey participants saw the events of 2020 driving a dialogue about how asset owners’ approach to insulating their portfolios may need to evolve. Just as the banking sector is re-examining how their ability to provide capital can be a tool to influence corporate behaviors, asset owners too are beginning to question their role and ability to use their portfolio allocations in a similar manner.

Expanding Model of Responsible Asset Ownership: The view that pre-financial risks linked to ESG are primarily a threat to only long-term asset valuations is changing quickly. Asset owners are beginning to expand their definition of responsible asset ownership to include management and mitigation of not just traditional financial risks, but pre-financial risks as well before they can cause financial impact.

This is prompting asset owners to re-assess how well their capital allocation is being used to signal their priorities to issuers. Many participants saw the current approach to ESG investing as failing to send a clear ESG message about the corporate behaviors that most concern investors. Nor does it provide the right incentives for companies to change such behaviors or allow asset owners to measure the reduction of

risks that such behavioral changes may create in their portfolios or clearly tie such improvements to their portfolio valuation.

These realizations are expected to push asset owners to seek enhancements to the investment process. Such improvements are seen addressing two specific goals: 1) Ensure that capital can be allocated in a manner that highlights to companies the specific areas where they need to amend their business practices, in order to mitigate the most urgent pre-financial risks before they can severely impact portfolio value, and 2) identify and model data inputs that can help asset owners assess how well their capital allocation is working to reduce pre-financial systemic risks at a portfolio level, to ensure that their investments are properly positioned for short-term resilience and long-term growth.

Changes in Investment Manager Approach to ESG May Re-Define Industry

As asset owners focus on better understanding and mitigating risk, investment managers are in turn expected to respond by transforming their approach to security selection, portfolio construction, risk management, and solution development. Some of these changes are evolutionary and reflect activities already underway in some organizations, and other changes envisioned by survey participants are more revolutionary and could foundationally alter how investment management is performed. We outline the progression of changes expected by survey participants below:

Shift from Blended ESG Scores to Individual Measurable Key Performance Indicators: As asset owners grapple with an expanding view of responsible portfolio management, there is a growing need for investment products that will help mitigate non-financial risks, not just address headline ESG risks. This need for a more action-oriented portfolio may require investment managers to re-think their use of data, to consider E, S, and G individually and at a more granular level, and to upgrade their integration methodologies to better tie capital allocation to desired behavioral changes in areas related to pre-financial risks.

Part of this evolution in approach is likely to be the development of a more robust set of E-, S-, and G-linked key performance indicators (KPIs) that can be used to monitor how the companies making up the portfolio, score against specific measures and allow investment managers to track the changes in such scores over time. KPIs can be grouped to more effectively target specific ESG themes. The KPIs used to measure climate change are going to look different from the KPIs used to assess sustainable land use or the KPIs that inform gender equality. Moving to this thematic level will be an important shift in order to better tie the allocation of investment capital to the desired changes in corporate behavior being sought by asset owners.


3 Citi Banking, Capital Markets & Advisory Debt Capital Markets based on data from Dealogic, updated as of 18th May 2020.4 Citi Business Advisory Services analysis based on data from “The world's largest fund managers – 2019”, Thinking Ahead Institute, https://www.thinkingaheadinstitute.org/en/Library/Public/Research-and-Ideas/2019/10/P_I_500_2019_Survey, “Global Asset Management 2019: Will These ’20s Roar?”,

The Boston Consulting Group, https://www.bcg.com/publications/2019/global-asset-management-will-these-20s-roar.aspx; and a proprietary data subscription to Cerulli.

These sets of E-, S- or G-themes linked to discrete sets of ESG KPIs, may begin to replace the current blended ESG scoring approach and allow for the creation of new benchmarks that can measure a new type of non-financial portfolio return that measures pre-financial risk mitigation.

Emergence of Dual-return Equity ESG “Theme Box” Products: Development of KPIs that could measure non-financial returns over time, might set the stage for a more revolutionary change in approach. For several years, survey participants have spoken about ESG as offering both a financial and “values”-based focus, but values are a difficult concept to measure. Shifting “values” to a set of thematic, benchmarked non-financial outcomes, each of which helps to reduce an E-, S-, or G-related risk in the portfolio may allow for the development of dual-return funds that offer both a financial return and mitigation of a specific type of pre-financial risk.

Measuring both the financial return and the improvements in pre-financial risks associated with ESG metrics, might allow for the creation of a whole new category of dual return investment options.

While these new funds may initially focus on “green chip” stocks — a subset of the stocks offering the best financial returns and the least exposure to negative E-, S-, or G-related risks – over time a more holistic set of offerings that provide a range of dual return E-, S-, or G-Value, Core, and Growth strategies may emerge. Having this range of product offerings would allow for not only best in class offerings, but higher risk-reward portfolios that could deploy investment capital to directly promote industry transitions and allow asset owners to benefit from the gradual improvement in pre-financial risks (ESG momentum), as well as from the impact that such improvements might have on companies’ financial returns.

Much like “style” boxes emerged in the 1990s to make allocating to the range of equity strategies more defined, a new range of ESG “theme boxes” may emerge in coming years to similarly help facilitate portfolio diversification. Inherent in the launch of these types of funds and in the shift to dual-return products, would be the opportunity for investment managers to reinvent active management, and develop new portfolio construction approaches that better meet investors’ needs and demonstrate new dimensions of manager expertise.

Expanded Use of Bonds & Structured Loans with Contractually Guaranteed KPIs: While dual-return equity products are seen as one likely area of innovation and equities today account for more than 50% of total ESG investments, the focus of investors and asset owners is already beginning to broaden to other asset classes. Survey participants see these products taking market share from equity ESG strategies over time. This shift would relate to the superior ability of bonds and structured loan products to ensure the reduction of pre-financial risks.

The ability of equity shareholders to influence corporate behavior is diffuse, as the only tools they have are their votes and active engagement with boards and management. By contrast, bonds and structured loans that can contractually build in metrics and goals are likely to provide a more direct route to creating change.

Using the same thematic approach and writing specific goals around the underlying E-, S-, or G-KPIs into the bond or structured loan issuances, could result in a second type of dual-return product and one that has an ability to better ensure desired pre-financial risk mitigation. Some traction in this direction is already emerging, as issuance of Green, Social, and Sustainability bonds rose to a record $286 billion in 20193 and some of those new offerings had explicit non-financial goals built into the contract language.

Expansion of Retail Solutions to Include Multi-Asset Class Dual-Return Products: Combining equities and bonds in multi-asset class solutions (MACS) is one of the fastest growing product areas in the investment management industry today—averaging an +11.0% CAGR for the past five years, while the broader market has grown at just +3.7%.4 The launch of dual-return multi-asset class solutions (dual-return MACS) may emerge as managers gain understanding about how to manage funds to achieve both financial and non-financial returns.

Construction of such instruments will require a new type of allocation calculation that finds the efficient frontier between financial returns, non-financial returns, and risk. Allocating capital within investment solutions is likely to become a more nuanced skill as certain instruments will ensure the financial return more readily while other instruments and approaches will generate non-financial returns more easily. These products too may provide another pathway for active managers as regardless of whether the solution is comprised of passive building blocks or actively managed sleeves, the construction and oversight of the fund would require an active approach.


The same thematic lens required to build effective equity products may carry over to define the solutions space, making it easier for retail clients to target their capital to the concerns that resonate most with their personal values. The growing use of model portfolios and managed accounts to create more aligned solutions is already beginning to transform the solution space, as discussed in our 2020 Industry Evolution report. Adding in an ability for individuals to both pursue their desired financial return and drive a measurable values-linked change, may offer an additional dimension to the personalization of portfolios. Dual-return MACS may thus become an important part of the industry adoption of tailored solutions.

Growing Focus on Shaping Pre-Financial Risk Mitigation Strategies in Institutional Solutions: For institutional investors that may utilize a growing share of dual-return products to enhance risk management and fulfill their expanding view of responsible asset ownership, solution portfolios are likely to look beyond publicly traded equity and bond offerings to include a larger share of alternatives, private companies, and real assets. These strategies can use expanded investment techniques or the ability to influence the contract terms of deals to concentrate the non-financial risk mitigation.

For those investors able to co-invest in private assets, there is an additional opportunity to be part of the co-creation of non-financial returns and to own the data sets that get created to measure the reduction of such pre-financial risks. As more institutional risk models look to incorporate such data, the ability to own the inputs that feed analytics might provide a secondary revenue stream for asset owners.

Outlook for Rapid Industry Change

Debates around the efficacy of ESG investing have been widespread in recent years, but much of the concern can be linked to the way in which investment managers have been using opaque, indicative scoring and the often indirect and limited way that teams incorporate ESG considerations into their investment thesis. Having more precise ways of measuring E-, S-, or G-related KPIs; showing how changes in such measures over time might reduce the portfolio’s pre-financial risks; and linking those KPIs to the appropriate E-, S-, or G-themes that allow asset owners to target their allocations in a manner that signals to companies which behaviors investors deem most concerning, could create an entirely new dialogue about ESG investing.

The opportunity for innovation and prospects for asset growth from the increased focus on ESG, have the potential to revitalize and reshape the investment management industry. In the following pages we dive in deeper to understand the past and present of ESG investing to help understand this inflection point and explore what the future may hold.


Section I: Understanding the Rise of ESG Investing

Survey participants had a lot to say on ESG investing in this year’s Industry Evolution survey interviews. The variety of opinions we picked up ranged from ESG transforming the entire fabric of the investment management industry to ESG not being a new type of investing at all. We determined to write this dedicated paper on ESG, since it was simply too complex and multi-faceted a story to fit within the context of our broader annual report published in June 2020. While we have written about ESG for many years, never in the history of our survey discussions has the topic garnered so much attention or spurred so much debate.

One observation that quickly became clear was that there is a tremendous amount of ambiguity around exactly what is meant by ESG and how it differs from other types of socially responsible investing. The complexity of the eco-system surrounding ESG was also a point of confusion, as the jargon and acronyms in this space are significant with governments, NGOs, specialty organizations, and industry groups all pursuing, publishing, and promoting a confusing mix of actual and proposed rules, frameworks, goals, and standards.

Underlying all of that activity is, however, a growing pool of assets that are being awarded to investment managers for the express purpose of addressing the needs of investors around ESG. This is not, as many initially framed it, a European phenomenon nor is it solely a climate change concern.

The range of asset owners across the globe that are shifting their portfolios toward ESG investing is significant and growing. This report looks at the roots of ESG investing, its expression in today’s investment landscape, how the demands of asset owners may prompt a significant change in the way that ESG investing occurs, and what that future may look like. Moreover, we try and explain why the Business Advisory Services team (that initially were ESG skeptics) have come to view these pending changes as potentially one of the most significant opportunities in decades for the investment management industry, based on the inputs we have gathered from our multi-year set of interviews.

Let’s start making that argument with some level-setting.

Separation of ESG from SRI and Impact Investing

While aspects of the umbrella “socially responsible investing” category have been around for decades,

ESG has taken a new form in recent years, with its influence now reaching a critical inflection point within the investment management industry. What was once a vaguely defined group of faith-based principles driving exclusionary stock selection practices has since evolved into a complex ecosystem of environmental, social, and governance considerations that are giving rise to new investing principles, valuation methodologies, and even business models.

While there are echoes of social issues that influenced responsible investing’s early days re-emerging, investors of all types now see a range of motivations for viewing capital allocation through an ESG lens. This is reflected in the rapidly growing interest in ESG and its expansion across a wider range of asset classes.

History of ESG and the Umbrella Category of SRI Investing

Beginning in the 1800’s, ethical codes and religious beliefs shaped ESG’s earliest years as Quakers and Methodists established socially responsible investing (SRI) guidelines for their followers. The groups launched the first ethical unit trusts in the U.S. and U.K. that excluded investments into companies engaged in either tobacco or gambling.1 Later, Muslims followed suit and used SRI to create funds that complied with Islamic law, or Sharia, that resulted in structures that prohibited investments into companies associated with weapons and alcohol. From these religious beginnings the term “sin stocks” emerged.2

This concept of excluding sectors and industries and of withholding capital to express values-based views continues to color many investors perception of ESG to the current day. Yet, while faith-based investing remains an attraction for many (having grown +33% over the past 5 years), this approach only accounts for ~$28 billion of AUM across 150 funds, according to Lipper, thus representing only a small proportion of today’s broader universe of ESG-aligned assets.3

1 “ESG Investing Comes of Age”, Jess Liu, Morningstar, February 11, 2020, https://www.morningstar.com/features/esg-investing-history2 “Evolution of ESG”, Hermes Investment Management, CityWire, May 11, 2018, https://citywire.co.uk/wealth-manager/news/evolution-of-esg/a11164863 “Faith-based Funds Attract Loyal Investors”, Jeff Benjamin, InvestmentNews, August 20, 2019, https://www.investmentnews.com/article/20190820/FREE/190829993


Socially responsible investing remained predominantly religiously-driven until the 1960’s, when exclusionary practices expanded to cover a broadening set of assets, not based on their alignment to religious principles, but instead based on their alignment to social principles linked to emerging anti-war, civil rights, and consumer rights movements.4 This expansion helps explain why the ESG space is often associated with “values” investing. This first evolutionary step is depicted in Chart 1.1.

By the 1970’s, companies were for the first time beginning to grapple with how to reconcile responsibility to their shareholders with the concerns of their broader ecosystem of interested parties. We can track the emergence of “stakeholder capitalism” to roots that emerged in this period, as evolving investment approaches sought to fuse faith-based with socially-progressive values, creating yet another recipe for “socially” responsible investing which in turn led to the creation of the first mutual funds reflecting faith-based values, civil rights-era sensibilities, and environmental concerns.5

However, during the 1970’s, using any “social” criteria in investing went against the orthodoxy, and investment vehicles were few. Critics were bolstered by Nobel prize-winning economist Milton Friedman’s popularization of the idea of shareholder theory, where a corporation’s primary responsibility was seen as delivering for their owners, which in turn meant that all decisions should be made with an eye toward profit-maximization with management taking on no explicit responsibility to either the public or society.6

4 “Evolution of ESG”, Hermes Investment Management, CityWire, May 11, 2018, https://citywire.co.uk/wealth-manager/news/evolution-of-esg/a11164865 “From SRI to ESG: The Origins of Socially Responsible and Sustainable Investing”, Blaine Townsend, Bailard Thought Leadership, June 2017, https://www.bailard.com/wp-content/uploads/2017/06/Socially-Responsible-Investing-History-Bailard-White-Paper-FNL.pdf?pdf=SRI-Investing-History-White-Paper6 Ibid7 Ibid8 Ibid9 “ESG Investing Comes of Age”, Jess Liu, Morningstar, February 11, 2020, https://www.morningstar.com/features/esg-investing-history

Chart 1.1: Key Milestones and AUM Growth in Socially Responsible Investing’s Evolution


1800’s+

Illu

stra

tive

AU

M G

row

th

1960’s+

Sustainable Investing

Global stakeholders begin to align capital to

affect social change and acknowledge

potential long-term environmental risks

Socially Responsible

Investing (SRI)

Ethical codes and religious beliefs

shaped the earliest interpretations of

SRI

Almost from the outset, however, there were opposing voices that joined the discourse on corporate purpose. By the late 1970s, the Reverend Leon Sullivan, a clergyman and civil rights leader, developed a code of conduct for companies, dubbed the Sullivan Principles, to promote social responsibility and to apply economic pressure in South Africa in response to the apartheid system of racial segregation.7 Nearly 25 years later, these same considerations would evolve to become part of the United Nation’s Global Compact.8

In the 1980’s, social and corporate pressure to divest from South Africa reached a tipping point, ultimately influencing public policy and contributing to the end of apartheid. Environmental issues also started to become a part of corporate responsibility in the 1980s. The Exxon Valdez oil spill in Alaska led to the creation of the Coalition of Environmentally Responsible Economies, bringing together investors, corporate leaders, and the public sector to explore a transition to a low-carbon economy.9

The term “sustainable investing” gained currency as global groups of stakeholders acknowledged the potential long-term risks of the environmental issues of the time and the idea of stakeholder engagement around environmental, social, and governance issues grew into the 1990’s. This was when the Domini 400 Social Index, now named MSCI KLD 400 Social Index, was launched as the first capitalization-weighted index built to track sustainable investments. This helped to further widen the funnel of assets being invested with an SRI-lens.


In the early 2000’s, the United Nations launched the Global Compact Initiative, a voluntary, corporate-citizenship effort based on a set of human rights, labor, environmental, and anti-corruption principles, encouraging the deeper integration of these topics into capital markets. In 2004, the Global Compact produced the landmark report “Who Cares Wins”, providing recommendations on how to incorporate the newly coined term “ESG investing” issues into analysis, asset management, and securities brokerage.10 The continued evolution of the umbrella SRI space is shown in Chart 1.2.

In 2006, the United Nations’ Principles for Responsible Investment (PRI) was launched, an effort aimed directly at engaging the investment community around these U.N. principles. This represented a watershed for ESG adoption. PRI has garnered more than 2,900 signatories from asset managers and institutional investors.11 The launch of PRI and the nascent investment framework of ESG put this approach firmly on the radar for investment managers, leading to a significant uptick in the growth of assets.

In 2009, the Global Impact Investing Network was launched, and impact investing became a new branch of consideration, along with socially responsible, sustainable, and ESG investing.12 In addition to values-

Chart 1.2: Key Milestones and AUM Growth in Socially Responsible Investing’s Evolution


1800’s+ 1960’s+ 2004

Illu

stra

tive

AU

M G

row

th





ESG Investing

The Global Compact produces the landmark

report “Who Cares Wins,” giving recommendations

on how to incorporate this newly coined term into

analysis


Investing (SRI)



SRI

based financial allocations, these specific investments aim to create an impact on society that would not otherwise occur. Manufacturing this non-financial return is the primary focus of these funds. Impact investing has further propelled the umbrella set of SRI AUM with the World Economic Forum estimating that $1 trillion of assets will be committed to impact investing by 2020, an estimate that implies annual growth of +$250 billion.13

Chart 1.3 lays out a timeline of the milestones in the evolution of ESG and puts the recent growth of impact investing and growth of ESG today into perspective. The acceleration is clear with assets estimated at over $30 trillion.

The majority of this AUM is often categorized as ESG, though the broader term Socially Responsible Investing continues to encompass the wide range of its evolutionary interpretations. The language and definitions remain variable and often concepts and terms overlap. The absence of definitional clarity to help tie these considerations directly to products has recently given rise to regulatory efforts to both protect investors and facilitate the channeling of capital to “sustainable” investment initiatives—a catchphrase that tries to encompass the range of ESG and SRI investing approaches.

10 “Who Cares Wins: Connecting Financial Markets to a Changing World”, The Global Compact, 2004, https://www.unepfi.org/fileadmin/events/2004/stocks/who_cares_wins_global_compact_2004.pdf11 “Evolution of ESG”, Hermes Investment Management, CityWire, May 11, 2018, https://citywire.co.uk/wealth-manager/news/evolution-of-esg/a111648612 Ibid13 “UN Sustainable Development Goals”, UN PRI, November 2017, https://www.unpri.org/sustainable-markets/sdgs


Chart 1.3: Key Milestones and AUM Growth in Socially Responsible Investing’s EvolutionIl

lust

rati

ve

AU

M G

row

th

1800’s+ 1960’s+ 2004 2009 Today


Investing (SRI)



SRI

ESG Suite Today

The majority of AUM is often referred to as ESG though Socially

Responsible Investing continues to encompasses a wide range of its

evolutionary interpretations

Impact Investing

Born out of a Rockefeller Foundation meeting, The Global Impact Investing Network launches and

impact becomes a new branch of SRI





ESG Investing

The Global Compact produces the landmark

report “Who Cares Wins,” giving recommendations

on how to incorporate this newly coined term into

analysis

Widening Scope of Asset Holdings


“What has changed over the last 10 years is that

ESG is now rooted in investment, not separate

from it.” — EMEA Investor

“ESG is a trend that won’t stop. In the very near

term, people might batten down that hatches, but

the trend towards ESG is unstoppable.” — NAM

Hedge Fund

“ESG is an idea that has been beaten to death over

the last 40 years. For now the shift is to be more

aware of a broader sense of responsibilities.” —

NAM Investor

“Previously if you were trying to ‘do good’, someone

else could buy the sectors you were excluding and

outperform you. That isn’t the case anymore.” —

NAM Asset Manager $500 billion - $1 trillion AUM

Current Regulatory Considerations & Evolving Global Frameworks

As always, understanding the regulatory landscape is of vital importance to addressing any opportunity and ESG is no exception. This is however a vast topic with varying interpretations and different implementations at the sectoral, regional, and global levels, so we will restrict our focus here to the impact of ESG-focused regulation and frameworks on the investment industry.

EU Becomes the Global Leader in Investment-Related ESG Regulation

Many policymakers and regulators were already beginning to think about how to shift capital flows towards sustainable investment before the recent pandemic, in part because of estimates about the costs that would accrue to governments as they sought to deal with the fallout from climate change and other related issues. Faced with now ballooning budget deficits as a result of the COVID-19 Crisis, this interest in linking capital to a broader set of “sustainable” goals has become an even more important concern.14 Initiatives and programs promoting favorable tax treatment and/or more lenient capital requirements to encourage capital flow are fragmented however and there is considerable variance globally.

14 “Government Bailouts are Beginning: We’re Keeping Track”, John Detrixhe, Quartz, March 17, 2020, https://www.economist.com/briefing/2020/03/19/governments-are-spending-big-to-keep-the-world-economy-from-getting-dangerously-sick


European regulators are taking the lead on legislation that could assist in managing the risks from climate change, natural disasters, environmental degradation, and social issues. Regulators in Europe have been working hard to increase the transparency and accountability of ESG investments. For example, in the European Union, the Disclosure Regulation which comes into effect in 2021 is intended to create a level playing field for ESG products and services. This is critical for investors because it makes certain disclosure requirements mandatory for any firm that markets their product as sustainable or environmental, including pensions, insurers, financial advisors, and individual portfolio managers.

Additionally, managers have to be able to justify their investments from an environmental or sustainability perspective if they wish to continue to label their funds as an ESG product. This latter requirement is intended to prevent “greenwashing”, the re-branding of previously non-ESG products as being ESG-compliant. The objective is to reduce barriers to investing in ESG products by making it easier for investors to compare fund performance against more standardized metrics, with the goal being that investors do not find it is “disproportionately burdensome to check and compare different financial products”.15

Asia is also starting to make strides in its regulatory regime, helping to make its maturing markets more attractive to capital as its investment management industry grows. For example, in May 2020, the Chinese Central Bank announced its decision to remove “clean utilization of fossil fuels” from a list of projects that could be classed as eligible for green bond financing, explaining that the decision was taken to “align to international standards.”16 China and Europe are also in talks on a joint “green task force” that would address shared sustainable finance taxonomies and further improve global regulatory disclosure standards.17

Interpreting and Aligning ESG Requirements around Fiduciary Duty

One of the significant variances in regulatory views around ESG investing has emerged around differing interpretations of how this approach fits within a definition of fiduciary duty. Some jurisdictions consider integrating ESG considerations to be a core part of the fiduciary role based on their view that these risks may affect the future value of assets held in portfolios.

Conversely, others believe that elevating ESG as its own unique investment consideration might negatively affect current returns, thus jeopardizing potential asset growth and being out of line with the responsi-bility to act in the end investors’ best financial interest.

The former CIO of the largest public sector pension in the world, the Japanese Government Pension Investment Fund (GPIF), Hiro Mizuno, who was a major force in the growth of ESG adoption in Asia, has been famously vocal noting that if investors or managers are creating value for a client for 20 to 30 years then “failing to take these [ESG] issues into account is against our fiduciary duty”.18

Many pensions share Mr. Mizuno’s perspective and see ESG issues as inextricably linked to their fiduciary duty. This is true even in the United States, a region seen by many as lagging in the ESG space. Large public plans like the Washington State Investment Board, CalPERS, and New York City Teachers have taken actions that emphasize ESG concerns. Other U.S. public pensions are less sure and cited the challenge of balancing long-term considerations and the potential of a fiduciary breach against ongoing concerns about whether or not an ESG focus is a negative for portfolio returns.19

Whereas public plans in the U.S. are balancing the pros and cons of how to incorporate ESG into their concept of fiduciary duty, private pension plans are often less forward leaning on ESG integration given the interpretation of fiduciary duties imposed by the corporate Employee Retirement Income Security Act (ERISA)20 and the Department of Labor (DoL) 2018 clarifications that instruct corporate plans to “not too readily treat ESG factors as economically relevant.”21

These cautionary notes may actually evolve into outright restrictions given a recently announced proposal from the Department of Labor that would instruct fiduciaries not to invest in ESG vehicles if they determine that the underlying investment strategy seeks to subordinate return or increase risk for non-financial objectives. Survey participants suggest that this could have a “chilling effect” on ESG’s adoption in the United States.

15 “Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088 (Text with EEA relevance)”, Eur-Lex, June 22, 2020, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex:32020R0852

16 “China to stop green bond financing for ‘clean coal’ projects”, Christian Shepherd and Don Weinland, Financial Times, May 29, 2020, https://www.ft.com/content/253f969c-37e0-42cd-9cdf-e06a5262fffe17 “China and EU to Form Taskforce on Green Taxonomies”, Responsible Investor, June 19, 2020, https://www.responsible-investor.com/articles/china-and-eu-to-form-taskforce-on-green-taxonomies18 “Why ESG Investing is a Fiduciary Duty of Asset Managers”, Bayani S. Cruz, The Asset, https://esg.theasset.com/ESG/39129/why-esg-investing-is-a-fiduciary-duty-of-asset-managers19 “Public Pensions Forced to Play Defense on ESG”, FundMap, https://www.fundmap.com/news/public-pensions-forced-to-play-defense-on-esg-investments/?pdf=4527920 “Financial Factors in Selecting Plan Investments, A Proposed Rule by the Employee Benefits Security Administration on 06/30/2020”, US Federal Register, June 30, 2020,

https://www.federalregister.gov/documents/2020/06/30/2020-13705/financial-factors-in-selecting-plan-investments21 “Field Assistance Bulletin No. 2018-01, Department of Labor, https://www.dol.gov/agencies/ebsa/employers-and-advisers/guidance/field-assistance-bulletins/2018-01


The DoL’s proposal is for a new investment duties rule that would clarify previous guidance on ESG investing. The proposal is designed, in part, to make clear that ERISA plan fiduciaries may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of non-financial objectives: “the duty of prudence prevents a fiduciary from choosing an investment alternative that is financially less beneficial than an available alternative.”22 The proposal acknowledges that ESG factors can be pecuniary factors, but only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories. The DoL’s proposed amendment of ERISA is worth quoting at length because of its potential significance:

“Public companies and their investors may legitimately and properly pursue a broad range of objectives, subject to the disclosure requirements and other requirements of the securities laws. Pension plans covered by ERISA are statutorily-bound to a narrower objective: management with an ‘eye single’ to maximizing the funds available to pay retirement benefits. Providing a secure retirement for American workers is the paramount, and eminently-worthy, ‘social’ goal of ERISA plans; plan assets may not be enlisted in pursuit of other social or environmental objectives.”23

However, as the Harvard Law School Forum for Corporate Governance argues, even if approved the amendment may, ironically, further the development of the ESG investment infrastructure: “if implemented, the new rules may spur further demand for comparable, decision-useful ESG data to help satisfy the burden imposed by the DoL to justify the inclusion of ESG factors in private-sector retirement plans.”24

A Growing Web of Voluntary Global Frameworks

Alongside the formal regulatory initiatives outlined above to help clarify and codify ESG metrics, there has been a rapidly shifting web of unregulated international frameworks. A number of non-governmental organiza-tions are encouraging many asset owners, managers, and corporates to voluntarily adopt standards, e.g., around ESG reporting and stewardship codes. The largest of these are the UN-backed Principles for Responsible Investment (PRI), Sustainable Accounting Standards Board (SASB), and the Global Reporting Initiative (GRI), as illustrated in Chart 1.4.

These voluntary international frameworks are beginning to serve several functions. First, they can create a potential blueprint for future legislative actions, and in the interim they begin to fill in some of the white space left by government regulators. Accordingly, many asset owners and asset managers see voluntary compliance with well-known frameworks as a way to get ahead of requirements which may become mandatory in the future.

Chart 1.4: Standards and Influencers in the Voluntary Reporting Framework Universe

PRIPrinciples for Responsible

Investing

GRESBGlobal Real

Estate Sustainability Benchmark

TCFDTask Force on Climate-

Related Financial

Disclosure

CDPCarbon

Disclosure Project

WDIWorkforce Disclosure Initiative

Other Emerging Frameworks

Influencers

Standards

GRIGlobal

Reporting Initiative

SASBSustainable Accounting Standards

Board

IIRCInternational

Integrated Reporting

Council


22 “Financial Factors in Selecting Plan Investments, A Proposed Rule by the Employee Benefits Security Administration on 06/30/2020”, US Federal Register, June 30, 2020, https://www.federalregister.gov/documents/2020/06/30/2020-13705/financial-factors-in-selecting-plan-investments

23 “Financial Factors in Selecting Plan Investments, A Proposed Rule by the Employee Benefits Security Administration on 06/30/2020”, US Federal Register, June 30, 2020, https://www.federalregister.gov/documents/2020/06/30/2020-13705/financial-factors-in-selecting-plan-investments

24 “DOL Proposes New Rules Regulating ESG Investments”, Martin Lipton, Wachtell, Lipton, Rosen & Katz, Harvard Law School Forum for Corporate Governance, July 7, 2020, https://corpgov.law.harvard.edu/2020/07/07/dol-proposes-new-rules-regulating-esg-investments/


Furthermore, as the number of signatories and adoptees grows, these frameworks are beginning to shape new norms among the peer set of asset owners and pensions. For example, in 2006 when the UN-backed Principles of Responsible Investing (PRI) were launched, the goals were adopted by 63 investment companies (asset owners, asset managers, and service providers) with $6.5 trillion in AUM. Today, it boasts over 3,000 signatories representing $85 trillion in AUM and momentum is clearly growing. While it took over a decade for the number of signatories to the PRI to reach 2,000 in November 2018 by May 2020, less than 18 months later, it had risen by more than 50% to 3,10925 and 72% of the total number of signatories today are investment managers.26

Institutional investors are navigating an intercon-nected and complex web of exposures when it comes to these mandatory and voluntary guidelines, as they often hold concentrated ownership positions in large numbers of countries and are subject to the influences of both formal regulation, and societal pressure to adopt voluntary frameworks. Survey participants suggest that understanding where each may overlap or inform the other is an increasing burden.

To combat this complexity and ensure their compliance with the variety of standards and frameworks across regions, asset owners (and investment managers) may, as they did with Europe’s data privacy rules (GDPR), eventually consider a “gold-plating” approach, adhering to the strictest standards and applying them across the entirety of their portfolio.

Adoption is already being assisted and accelerated by the mutual reinforcement of voluntary frameworks. For example, the Financial Stability Board’s (FSB) Taskforce on Climate-related Financial Disclosures (TCFD) that develops voluntary climate-related financial risks disclosures for use by companies, is being touted by the UK Government that recently set out its expectation for all listed companies and large asset owners to disclose in line with the TCFD recommendations by 2022.27 This follows the U.N. PRI’s move to make TCFD-based reporting mandatory for its signatories this year.28

“It doesn’t matter how skeptical I am about the

return potential for ESG. If 51% of the market

starts to price according to ESG, then it’s right.” —

European Asset Manager


Chart 1.5: Half of Top 10 Asset Owners are UN PRI Signatories

Government Pension Investment Fund (Japan)$1.4T19%

Government Pension Fund of Norway$1T14%

China Investment Corporation$0.9T13%

Abu Dhabi Investment Authority$0.7T10%

Kuwait Investment Authority$0.6T

8%

Federal Retirement Thrift of the United States$0.6T

8%

National Pension of South Korea$0.6T

8%

Hong Kong Monetary Authority Investment Portfolio (HKMA)$0.5T

7%

Saudi Arabia Monetary Authority Foreign Holdings (SAMA)$0.5T

7%ABP (Netherlands)

$0.5T6%

Top 10 AssetOwners$7.2T38%#11-100 Asset

Owners$11.8T62%

PRI Signatories

Top 100 Largest Asset Owners Globally

$19 Trillion Total AUM

Top 10 Asset Owners Globally

$7.2 Trillion Total AUM

Source: Citi Business Advisory Services’ analysis based on data from the Thinking Ahead Institute’s Asset Owner 100, https://www.thinkingaheadinstitute.org/en/Library/Public/Research-and-Ideas/2019/11/AO100_2019_Survey and the UN PRI

signatory directory, www.unpri.org

Chart 1.6: Categories of Asset Owners Driving ESG

Source: “2019 ESG Survey”, Callan Institute, 2019, https://www.callan.com/wp-content/uploads/2019/09/2019-ESG-Survey.pdf

75%

50%

25%

0%

58%

Endowments

% o

f A

sset

Ow

ner

s A

dopti

ng E

SG

Public Foundations Corporates

49%44%

19%

U.S. Asset Owners Incorporating ESG Factors into Investment Decisions

by Type


In 2016, CalPERS, the largest public pension fund in the United States, rolled out their five year plan for governance and sustainability considerations across their investment portfolio.30 It was also around this time that the world’s largest pension, Japan’s $1.3 trillion Government Pension Investment Fund (GPIF) announced its plan to increase its allocation of equities to socially responsible and environmentally-focused investing from 3% to 10%.31 And in 2019, 50 financial institutions, primarily pension funds and insurers in the Netherlands, signed the Climate Agreement and have committed themselves to reporting on the climate impact of their investments from 2022.32

These asset owners are well positioned to influence the future direction of companies. Collectively they own more than 50% of the equity across 10% of the world’s largest companies; and in half of the world’s largest companies, the three largest shareholders—typically large public pensions—own more than 50% of the firm’s shares.33 This ownership concentration in combination with many of these leading asset owners prioritizing ESG considerations, as reflected in commitments such as becoming PRI signatories, is adding serious heft to the demand for ESG aligned investment products.

Asset owners have additionally been joining forces to influence corporate behavior to collectively increase their influence over a wider range of E, S, and G issues.

As early as 2016, six of the world’s largest institutio-nal investors – Canadian Pension Plan Investment Board (CPPIB), Ontario Teachers’ Pension Plan in Canada, ATP and PGGM in the Netherlands, Singapore’s GIC and New Zealand’s Superannuation Fund – announced a $2 billion initial investment into their newly-launched Long Term Value Creation Index, which includes nearly 250 companies that are in the top tier of corporate governance scoring, meet high financial standards and generate a threshold amount of return on equity (ROE) criteria.

In 2017, a group of investors banded together to form The Climate Action 100+, an organization that today cites more than 450 investors with over $40 trillion collective assets under management.34 This organization seeks to the world’s largest corporate greenhouse gas emitters take the necessary action on climate change. In its inaugural climate change risk report in 2019, CalPERS highlighted its assessment that 20% of its $180 billion equity portfolio faced material financial risks due to climate change and stated that being a global investor came with significant responsibility to utilize engagement as a tactic to change corporate behavior.35

These and a host of other sustainability efforts by major institutional asset owners highlight the global groundswell of interest in more deliberate and collective action around environmental, societal, and governance issues, and illustrate the impetus for growth around the world in ESG-aligned investment products.

“There is a need to allocate savings more long-term

to productive investment strategies and the key is

to keep the complexity down to a minimum. Taking

ESG into perspective, clearly we want to make

sure that the investments we are putting into our

portfolio are going to be sustainable, reliable, and

deliver returns over that time.” — EMEA Investor

“ESG reflects our responsibility to our investors.

But it’s both leadership and a fund reflection.

On a fundamental level, we share the belief of our

investors when they say what they want and we

collaborate together. They play a role, and we play

a role.” — EMEA Investor

Growth in ESG-Aligned Assets under Management

Determining the exact amount of the world’s assets being managed via ESG investing is a somewhat debatable topic. At the highest level, many cite the Global Sustainable Investment Alliance’s (GSIA) figures. Their analysis presented in Chart 1.7 shows rapid growth with total AUM increasing from $13 trillion in 2012 to $31 trillion in 2018.

GSIA only publishes their estimate every 2 years, however, and this figure was from the end of 2018. Moreover, their total includes assets where investment teams reportedly consider, but may not direct investments using ESG principles. Section II will explore how important this distinction is in more depth.

Another GSIA report is not due out until the spring of 2021. The growing emphasis on ESG in our survey interviews over the past 2 years seems to indicate a significant acceleration of interest since their last report. This perception is backed up by the somewhat limited data points available that focus exclusively on ESG funds.

30 “CalPERS adopts first-ever ESG policy plan”, Annabelle Ju, Secondaries Investor, August 17, 2016, https://www.secondariesinvestor.com/%EF%BB%BF-calpers-adopts-first-ever-esg-policy-plan/31 “CSR: Pension Funds Turn Up ESG Dial”, Helen Avery, Euromoney, August 3, 2017, https://www.euromoney.com/article/b144mx79fm2bw1/csr-pension-funds-turn-up-esg-dial32 “Fifty financial institutions sign Dutch climate goal agreement”, Sunniva Kolostyak, European Pensions, July 11, 2019, https://www.europeanpensions.net/ep/Fifty-financial-institutions-sign-Dutch-climate-goal-agreement.php33 “Owners of the World’s Listed Companies”, OECD, 2017, http://www.oecd.org/corporate/owners-of-the-worlds-listed-companies.htm34 Climate Action 100+, https://climateaction100.wordpress.com/about-us/35 “The Importance of Corporate Engagement on Climate Change”, CalPERS, December 2019, www.calpers.ca.gov/docs/corporate-engagement-climate-change.pdf


Chart 1.7: Global ESG AUM Growth

$30

$20

$10

$0

$13

$18

Global ESG-Aligned AUM

2012 2014 2016 2018

AU

M(U

SD

Tri

llio

n)

$23

$31

Source: 2012-2018 Global Sustainable Investment Alliance annual review surveys, http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf

According to such reporting, sustainable funds attracted assets at record levels in 2019: Inflows into European funds dedicated to sustainable investing surged to +$132 billion and a growing number of funds with climate-dedicated mandates were launched.36 Net flows into open-ended and exchange-traded sustainable funds available to U.S. investors totaled +$20.6 billion, nearly four times the previous annual record set in 2018 according to analysis from Morningstar’s review of 300 funds.37

Notably, to be considered within this Morningstar analysis, funds needed to demonstrate a significant emphasis on ESG. The figures did not include those that employ only limited exclusionary screens or the ballooning number of funds that only consider ESG factors in a limited way as a part of their security selection.

This need to clarify the fund universe in such precise terms is a sign of how the commitment to ESG is often at odds with the expression of ESG in investor portfolios.

ESG as a Sidecar to the Investment Process

While ESG has been a growing consideration in the investment process, there remains a significant gap between many of the public commitments being released by investment managers to align their portfolios to ESG criteria and the reality of how this is being accomplished. Cerulli Research estimates that 88% of total assets being managed in the public markets are affiliated with a signatory of the U.N. PRI, but this stands in stark contrast to a 2019 review of product documentation and fund prospectuses that found that only 4.5% of funds affiliated with PRI signatories explicitly cited ESG criteria as part of their investment process.38

This mirrors the wide differences reported in total ESG AUM due to differing interpretations and methodologies — some estimates are $12 trillion and some are closer to $30 trillion. Our bottom-up analysis of funds explicitly listed as ESG products provides a number closer to $3 trillion. While significantly lower than the GSIA headline figure, it is important to note that even the smallest $3 trillion estimate puts assets explicitly being managed under ESG mandates on par with the size of the entire hedge fund industry.

Disparities clearly reflect the phenomenon of “green-washing” wherein existing funds are recast as considering ESG, but where there is no discernible change in the underlying investment process. This allows firms to market themselves as offering ESG products to benefit from the growing interest in such products. In 2019, Morningstar identified more than 250 funds in Europe which had been relabeled ‘sustainable’ from previously being ‘traditional’, and which represented an estimated 10%-20% of the European sustainable fund universe.39

Breakdown of Global AUM

Regionally, interest in ESG investing is still very uneven. According to GSIA, this regional variation is driven by a mix of industry maturity, regulation, and cultural factors.40 Europe registers the highest level of interest in ESG investing with $14 trillion AUM in 2018, but the U.S. is not far behind at $12 trillion and has been growing more quickly. Between 2012 and 2018, European assets increased by +56% whereas U.S. AUM grew by +200%. While significantly smaller, Asian interest is increasing the most rapidly. These figures are detailed in Chart 1.8.

36 “European ESG Funds Pull in a Record $132 Billion in 2019”, P&I, January 31, 2020, https://www.pionline.com/esg/european-esg-funds-pull-record-132-billion-201937 “Sustainable Funds Flows in 2019 Smash Previous Records”, Jon Hale, Ph.D., CFA, Morningstar, January 10, 2020, https://www.morningstar.com/articles/961765/sustainable-fund-flows-in-2019-smash-previous-records38 “Asset Managers Say They’re Into ESG. Their Product Descriptions Say Otherwise”, Amy Whyte, Institutional Investor, November 14, 2019, https://www.institutionalinvestor.com/article/b1j1161j66t61g/Asset-Managers-Say-They-re-Into-ESG-Their-Product-Descriptions-Say-Otherwise39 “Surge in Funds Rebranding as Sustainable”, Elizabeth Stuart, Morningstar, April 21, 2020, https://www.morningstar.co.uk/uk/news/201590/surge-in-funds-rebranding-as-sustainable.aspx40 “2018 Global Sustainable Investment Review”, Global Sustainable Investment Alliance, 2018, http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf


European Asset Owners Lead the Way on ESG

Europe dominates the ESG AUM landscape with $14.1 trillion at the end of 2018. A 2019 global study found that Europe was the dominant region globally for ESG integration in the investment process, and that the combined forces of increased regulatory pressure for corporate disclosure alongside Europe’s leadership around climate change were greatly contributing to sharpening investor perceptions and preferences around sustainability.41 Environmental funds are still the single largest themed category however, and despite representing a relatively small total share, they dominate both in terms of number of funds and total assets.42

ESG adoption and leadership by Northern European asset owners has historically been strong, and they continue to actively evolve their practices. For example, in Norway, Norges, the world’s largest sovereign wealth fund that derives its base assets from petroleum extraction, plans to drop oil and gas stocks from its portfolio as it prepares for a shift away from fossil fuels and move towards sustainable investing.43

APAC ESG AUM Growing Rapidly, From a Smaller Base

The ESG story in Asia is unfolding at the sub-regional or national level and there is significant variation. Japan is the world’s third largest center for sustainable investing after Europe and the U.S. As noted throughout this section, Japan’s GPIF has led much of the regional gain in ESG aligned AUM in recent few years, but other countries are acting to narrow the gap. In Australia, a recent survey from ‘Responsible Investment Association Australasia’ that included 125 Australian investors with a combined AUM of A$1.7 trillion ($1.1 trillion), concluded that allocations to impact strategies in Australia could potentially grow to A$100 billion over the next five years from A$19.9 billion at the end of 2019.44 In India ESG-linked assets are estimated to grow from $30 billion at the end of 2019 year-end to $240 billion over the next 10 years.45

Singapore has announced intentions to establish itself as a hub for green finance in the region,46 and in China, new regulations are set to come into force this year that will make disclosure of environmental factors mandatory for Chinese listed corporations and primary bond market issuers. China’s regional ESG leadership ambitions can also be inferred from the rise in the number of PRI signatories in China growing from just 7 in 2017 to 33 in 2019. In particular, many are looking to see how much this emphasis on ESG principles translates into China’s vast One Belt One Road initiative.

Chart 1.8: Global ESG AUM Growth by Region

Source: 2012-2018 Global Sustainable Investment Alliance annual review surveys, http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf

$15

$10

$5

$0Europe US Canada AsiaAustralia/NZ

$9

$4

$1 $1$1

$1 $1$2

$0 $0 $0 $0 $0

$2

$7

$9

$12$12

$14

$11

2012 2014 2016 2018

AU

M(U

SD

Tri

llio

n)

41 “Europe leads institutional investors’ embrace of ESG”, Hazel Bradford, P&I, September 4, 2019, https://www.pionline.com/esg/europe-leads-institutional-investors-embrace-esg42 “European Responsible Investing Fund market 2019: A focus on “tagged” sustainable funds”, KPMG, June 2019, https://assets.kpmg/content/dam/kpmg/lu/pdf/lu-en-European-Responsible-Investment-Fund-2019.pdf43 “Europe leads the $31tn charge on sustainable investing”, Richard Henderson, Financial Times, June 1, 2019, https://www.ft.com/content/fef1a4fc-8354-11e9-b592-5fe435b57a3b44 “Australian Impact Investor Insights, Activity and Performance Report 2020”, Responsible Investment Association Australasia, 2020, https://responsibleinvestment.org/wp-content/uploads/2020/06/Benchmarking-Impact-2020-full-report.pdf45 “ESG Investing Scenario in India”, Yes Bank, December 2019, https://www.yesbank.in/pdf/esg_investing_scenario_in_India#:~:text=In%20India%2C%20ESG%20investing%20has,in%20the%20next%2010%20years46 “ESG investment starts to gain a foothold in China”, Fiona Reynolds, Nikkei Asian Review, January 7, 2020, https://asia.nikkei.com/Opinion/ESG-investment-starts-to-gain-a-foothold-in-China


North America’s ESG Growth Has Been Relatively Slower, Focused on Governance:

Though its level of interest in ESG investing is rising, proportionately investors in the U.S. have been slower to adopt ESG than in other regions, particularly when measured against the overall size of its investment pool. Moreover, much of the interest cited around ESG from U.S. investors tilts in a different direction than in Europe. Rather than a focus on climate change and environmental issues, U.S. investors focus more extensively on governance issues, especially around disparities such as executive to worker pay ratios and gender balances on boards and in management suites.

In part, this helps to explain why debate about whether ESG is a separate approach to investing at all often originates from U.S. market participants. Governance factors are more commonly seen as a part of existing financial models, particularly compared to environmental considerations. In a 2019 study by CoreData Research, that measured engagement with various ESG strategies on a scale of 1 to 10, North America had the lowest score of 3.6, versus a global average of 4.2.47 Only 22% of U.S. public plans even mention the term ‘ESG’ or ‘responsible investing’ in their annual reports, websites, or other public documents, compared to 78% of their global peers.48

There are, however, signs that this situation may be changing. According to a recent ‘Global Sustainable Fund Flows’ report by Morningstar, while U.S. investment managers account for less than 10% of sustainable funds and 14% of total sustainable assets globally, the region accounted for 23% of global flows in Q1 2020 or +$46 billion of net inflows.49 Survey participants cited growing social anxiety in the U.S. around income and racial inequality as a result of the COVID-19 crisis, and many speculated that this may work to shift the region to a more dispersed ESG focus and away from as heavy an emphasis on G factors.

Highlights from Other Areas around the World:

While ESG-linked AUM totals from other regions are just beginning to grow, there does appear to be significant interest.

According to a 2019 Natixis ESG survey, 85% of Latin American investors want to be able to allocate to funds that line up with their values, and 63% of investors consider their investments as an opportunity to make a positive social impact. Further, 54% of the institutional investors surveyed say they are currently incorporating ESG factors into their investment process.50

Sustainable investing in Sub-Saharan Africa is also seen as having a niche foothold at present, anchored in the region’s largest investment market, South Africa. Regulations in that country require that pension fund investments include ESG considerations in their portfolio, and in 2017 the Johannesburg Stock Exchange launched a green bond segment.51

“In Europe it would be a non-starter to not be an ESG

player, but in Asia it is still in the nascent stage.

There is a lower competition in Asia and probably

a chance to be ahead of the curve.” — APAC Asset

Manager


Section II: Current ESG Investments Focus on Managing

Headline Risk

The techniques used to invest funds with an ESG lens are just emerging. Early efforts have focused on broad brush approaches that look to redress the headline risk of having companies with poor ESG records in the portfolio. These investment strategies either look to exclude companies, or integrate ESG alongside a wide array of other financial considerations in determining the proper portfolio weighting of a security.

1 “2018 Global Sustainable Investment Review”, Global Sustainable Investment Alliance, 2018, http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf

Chart 2.1: ESG Investing Approaches: Negative Screening

$19.8

$17.5

$9.8

$4.7

$1.8

$1.0

$0.4

$0 $5 $10 $15

USD Trillions

Negative/Exclusionary Screening

ESG Integration

Corporate Engagement & Shareholder Action

Norms-Based Screening

Positive/Best-In-Class Screening

Sustainability Themed Investing

Impact/Community Investing

$20 $25

Source: “2018 Global Sustainable Investment Review”, Global Sustainable Investment Alliance, 2018, http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf

Global Utilization of ESG Strategies: 2018Total AUM: $30.7 Trillion4

Data Includes Double-Counting Across Multiple Investment Approaches

There are several issues with these approaches. They do not tie the allocation of investment dollars to specific behaviors that the investment manager is looking to highlight, and thus the effectiveness of these investments to incentivize actual change in corporate behavior is uncertain. The data approach used to “score” companies is murky and many survey participants questioned its usefulness. The way in which investment managers incorporate ESG into their organizations is also highly divergent, and in some models, there are other groups beyond the investment teams focused on ESG and shaping firm policy on how ESG gets reflected in portfolios, potentially undermining either the financial return or the ESG signal.

Strategies that engage companies more directly — stewardship and impact funds — may be more effective in highlighting desired ESG behaviors and soliciting behavioral change, but the measures used to evaluate their success often focus on actions taken as opposed to outcomes achieved. Moreover, of the approaches in use today, these strategies currently attract the smallest amounts of AUM.

Negative Screening Dominates Early Investment Efforts

The approach to ESG investing that currently draws the widest participation is negative screening, a technique being applied to $19.8 trillion or 60% of the $30.7 trillion of ESG-aligned AUM in 2018 as listed by GSIA. This pool of assets has grown by nearly a third between 2016 and 2018.1 Its dominance can be seen in Chart 2.1.


2 “Demystifying Negative Screens: The full implications of ESG Exclusions”, Schroders, December 2017, https://www.schroders.com/getfunddocument/?oid=1.9.2890163

Negative screening centers on the exclusion of individual companies or entire industry sectors from a fund’s investible universe, based on the category’s perceived creation of an undesirable environmental, social, or governance outcome. Traditionally, these sectors have included areas such as fossil fuels, tobacco, and arms manufacturing. Negative screening approaches reflect ESG’s roots as described in Section I and represent an evolution of the SRI methodology. It marks the easiest and least quantitative approach to aligning a portfolio.

However, despite its widespread adoption, survey participants noted that negative screening is the most simplistic, and potentially least effective way for investors to signal to companies what behaviors they would like to see change. By withholding funds altogether and opting to not be a shareholder, investors are giving up the opportunity to engage the company on their goals.

Moreover, they noted that the predominance of this strategy has often tainted the wider ESG dialog. Many of the companies being excluded from a portfolio may have generated significant risk-adjusted returns for investors. This has resulted in an ongoing perception issue for ESG investing that it is about “doing good” rather than “doing right” in terms of fulfilling the fiduciary duty to pursue the best possible financial return.

To reduce perceptions that these strategies simply address headline risk and that they can negatively impact portfolio returns, attempts to introduce more quantitative rigor to the approaches are emerging. These include creating more sophisticated exclusion-ary screens by isolating company exposures around specific revenue streams, linked to discrete activities to understand how their behavior impacts the company’s overall operations. Investors report using analytics and screens provided by MSCI, RepRisk, or other third-party providers to set different thresholds around the permutations of impact-exposure combinations. More sophisticated screening can also facilitate a cross-sector view of company exposures by, for example, analyzing how participation in a certain supply chain exposes a company to an undesirable theme.2

While increased analysis may provide more justification and precision to negative screening strategies, it cannot redress issues about how such exclusions can limit the effectiveness of a portfolio. Increasing awareness about the limitations of the negative screening methodology is driving investment managers to use data in more focused ways within an evolving evaluation framework, and approach ESG assessment more scientifically.

“More than 50% of the economy is based on carbon

so it is not practical to say you are going to avoid

carbon.” — APAC Asset Manager $500 billion -

$1 trillion AUM

“I’m a little skeptical. Everyone has been marketing

it and there is also some concern of regulating it.

I’m still convinced that it is a key pillar, but the

way it is being done is a concern.” — Global Asset

Manager >$1 trillion AUM

“The biggest problem with ESG is the greenwashing.

It’s like going to church on Sunday, getting your

conscious cleared, then committing crimes on

Monday to Friday.” — Global Asset Manager

>$1 trillion AUM

Emergence of ESG “Scoring” Provides New Investment Input

Rather than simply choosing to forego certain investments, other ESG investing techniques attempt to quantify a company’s ESG profile and create a relative ranking of companies. ESG scoring approaches have emerged to help guide the integration of these factors into the broader science of financial analysis.

One immediate benefit of this shift in approach is that it enables managers to invest in high performing companies within sectors that may have been historically shunned by the ESG community, but that were not expressly prohibited. Survey participants cited sectors like energy, mining, and timber as examples.

The path to having ESG data inputs is not straightforward, however. Survey participants raised many concerns about existing data providers.

Originally company-specific ESG data was sparse. Data providers relied almost exclusively on corporations to self-report on their activities and objectives. Such inputs were usually extracted from firms’ annual voluntary corporate social responsibility reports and then used to measure various E, S, and G considerations. This methodology tended to favor larger firms that could afford to hire resources to understand the language and focus areas influencing their ESG perception and to use these criteria to skillfully communicate their messaging.


Chart 2.2: Conceptual Model of Current ESG Scoring

Data

Ben

chm

ark

Pro

vid

er E

EScore

SScore

GScore

S Blended Score

Proprietary Methodology

CompanyProvided Data

G


Data providers extracting the inputs and translating them to ESG scores have also been hesitant to disclose their exact methodologies, considering it proprietary information. Many survey participants expressed concerns that data providers may rely on a mechanical “check the box” approach to extracting numbers and language from a company report. They worried that data providers do not perform any independent assessments to test the veracity of the data nor hold the companies accountable to how well they fulfill their stated goals. Interviewees worried that the resultant scores may thus reflect the quality of the company’s communication and messaging as much as the underlying reality of their actions and behaviors.

Traditionally, ESG data providers delivered an aggregate rating for a company that represents a combined assessment of all the individual E, S, and G considerations. Having a single blended score to rate a company may be appealing in its simplicity, but survey participants pointed out that distilling variables as disparate as carbon emissions, the number of women on the board, and the labor practices of partners across a company’s supply chain into a single number makes little sense.

Chart 2.2 illustrates this process whereby the data vendor ingests the data that the company chooses to supply, and using their opaque proprietary methodology creates an E-, S-, and G-score that then gets combined into a blended “ESG” score which they then sell as part of the overall industry and sector rankings.

While a step away from exclusion based on company perception, this blended score approach offers managers little reliable insight. Survey participants noted that even apples to apples comparisons of like companies in like sectors may not be reliable due to the variability and incompleteness of the unverified data inputs and the fundamental incomparability of many of the issues. Despite these concerns however, utilization of these ESG scores underpin the majority of ESG integration approaches in use today.

“We’re now integrating ESG scores into our

investment processes. The problem is the low

reliability of the ESG data providers.” — APAC

Asset Manager


Chart 2.3: ESG Investing Approaches: ESG Integration

$19.8

$17.5

$9.8

$4.7

$1.8

$1.0

$0.4

$0 $5 $10 $15

USD Trillions

Negative/Exclusionary Screening

ESG Integration

Corporate Engagement & Shareholder Action

Norms-Based Screening

Positive/Best-In-Class Screening

Sustainability Themed Investing

Impact/Community Investing

$20 $25

Source: “2018 Global Sustainable Investment Review”, Global Sustainable Investment Alliance, 2018, http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf

Global Utilization of ESG Strategies: 2018Total AUM: $30.7 Trillion4

Data Includes Double-Counting Across Multiple Investment Approaches

3 “2018 Global Sustainable Investment Review”, Global Sustainable Investment Alliance, 2018, http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf4 “New Approaches to Active Management & The Need for Manufacturing Flexibility in an Era of Asset Class & Factor Investing”, 2017 Industry Evolution report,

Citi Business Advisory Services, October 17, 2017, https://www.citivelocity.com/cv-content-web/geo/alerts/equity/EA59e6472b498ec73537495f000.pdf

Overall, integration is the second most popular technique being utilized in ESG investing and this approach influences over half of the assets being deployed under the ESG umbrella. As shown in Chart 2.3, integration ranks just behind negative screening. Assets controlled by proponents of the integration approach grew strongly between 2016 and 2018, registering a +30% CAGR in the period.3

ESG Integration Layers New Variables into Factor-Driven Portfolio Construction

A range of investment strategies have emerged that use the ESG score as an input. There is considerable variation in the manner by which ESG elements are utilized to inform the weighting of the securities in a manager’s investment portfolio. Yet, underlying the approach are some basic similarities. Nearly all of the portfolios apply consideration of ESG variables to a traditional capital-weighted universe and proceed to overweight or underweight companies based on a combination of their financial factors and their ESG score.

To understand the differences in integration approaches, we will step back for a moment and review how traditional financial analysis has evolved without any specific focus on ESG. This is a topic that we have covered at length in our past Industry Evolution surveys.

As noted in past reports, more and more portfolios are looking through the broad asset class allocation to focus on the financial factors that inform portfolio construction and management. Survey participants have spoken at length in our past reports about how they use a combination of such factors in their investment models, looking to accentuate certain types of exposures and control others. We have presented this concept via a construct we call the “factor cube”.

There are three main types of financial variables considered as part of the factor cube.

Allocation factors inform the make-up of the holdings in the portfolio and consider the risks associated with the specific geography, sector,

citi velocity - from evolution to revolution: esg ......source: citi business advisory services; aum...

Documents